In early April 2021, the Ministry of Finance published explanations on transfer pricing adjustment. These explanations do not constitute the source of law; they are rather an attempt at offering some insight into how to apply legal regulations on transfer pricing adjustments between related entities. In this post, we are going to take a closer look at the most important insights included in the explanations published by the Ministry of Finance.
A transfer pricing adjustment means correcting (adjusting) transfer prices applied by related entities. Within the meaning of Article 11e of the CIT Act (hereinafter: KCT11e), the aim of this adjustment is to adjust transfer prices for a given period to the amount consistent with the arm’s length principle. KCT11e is a retroactive adjustment, i.e. it relates to past transactions between related entities. KCT11e is a consequential adjustment used to align the settlements to the level consistent with the arm’s length principle. What should be emphasised, however, is that not every adjustment of transfer prices is a transfer pricing adjustment within the meaning of KCT11e.
When is a transfer pricing adjustment consistent with the meaning of KCT11e?
Already at the stage of concluding a transaction with a related entity, the taxpayer should ensure that the terms and conditions of the controlled transaction are in line with the arm’s length principle. A transfer pricing adjustment within the meaning of KCT11e only occurs when despite the fact that the taxpayer has acted reasonably and fairly in concluding the transaction in order to comply with the arm’s length price setting approach (ex-ante), the transfer price applied by the taxpayer is not at arm’s length ex-post. In other words, KCT11e must result either from a change of relevant circumstances or the transfer pricing approach based on budgetary data that is adjusted for actual revenue/costs at the end of the period.
Thus, an adjustment within the meaning of KCT11e is neither an accounting error nor an obvious mistake, as well as an adjustment resulting from other reasons, e.g. discount, rebate or a changed scope of services provided between related entities. Any adjustment which is not KCT11e should be performed in line with general conditions (also in terms of its allocation to a relevant period/tax year).
What is interesting, KCT11e may also be made in relation to a related party which is not directly a party to a transaction concluded by the taxpayer. It is most often the case of a relation between a manufacturer with a limited scope of functions, assets and risk and a central entity managing a supply chain and not always being a party to direct transactions with the manufacturer.
The explanations of the Ministry of Finance fail to specify the period and frequency taxpayers should be making KCT11e. Thus, adjustments within the meaning of KCT11e should be as a rule of thumb made as often as unrelated entities would do under comparable circumstances. What should be noted, as well, is that the provisions of the CIT Act do not define what accounting document should document KCT11e. However, if the related entity issues a document being the basis for KCT11e and provides it to the taxpayer, the receipt of this document fulfils prerequisite no. 3 defined in Article 11e of the CIT Act, i.e. the condition of having a statement by the related entity on transfer pricing adjustment. This is particularly important when making downward adjustments.
Different treatment of upward and downward adjustments
A taxpayer making a downward KCT11e adjustment must have a statement that the related entity has made a transfer pricing adjustment in the same amount as the taxpayer (during the epidemic or epidemic state, taxpayers are exempt from this obligation). However, a taxpayer making an upward adjustment is not obliged to do so.
The Ministry of Finance has also confirmed that a downward KCT11e adjustment that fails to meet the conditions specified in Article 11e item 1-5 of the CIT Act cannot be made in line with general conditions under Article 12 par. 3j-3m of the CIT Act (on the revenues side) and Article 15 par. 4i-4k of the CIT Act (on the expenses side). When it comes to an upward KCT11e adjustment that fails to meet the conditions specified in Article 11e item 1-2 of the Cit Act, it should be made in line with general conditions.
As a result of this different treatment of upward and downward adjustments, upward adjustments resulting in increased revenue result in additional revenue being taxed. However, if the taxpayer incurs additional expenses (downward adjustment) in similar circumstances, these expenses shall not be recognised as deductible expenses. That is why you need to be aware of this different treatment of upward and downward adjustments by the Ministry of Finance. If the taxpayer fails to meet the conditions set forth in KCT11e, they may still make an upward adjustment in line with general conditions; however, the same is not possible in the case of a downward adjustment.
Taxpayers who want to apply the mechanism of transfer pricing adjustment must meet a full range of preconditions: firstly, they must ensure they apply arm’s length prices with related entities already during the year, because if this precondition is not met, they will not be allowed to apply any downward adjustment. What is more, in order to apply a downward adjustment you need to have a statement from a related entity that they have made a transfer pricing adjustment in the same amount as you have (during the epidemic or epidemic state, taxpayers are exempt from this obligation). Another precondition you have to meet if you want to make a KCT11e adjustment is that you have to prove that this adjustment is a result of either a change of relevant circumstances during the tax year or learning about revenues actually generated or expenses actually incurred. If you fail to meet the above conditions or do not confirm your transfer pricing adjustment in the annual tax return, you will not be allowed to make a downward adjustment.
Considering the above, taxpayers who intend to apply the transfer pricing adjustment mechanism within the meaning of KCT11e should ensure that their transfer pricing adjustments of transactions with related entities are properly documented and justified.
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